Cartoon of the Day: Crash Tech Dummies?

"The Nasdaq moved back into full-blown correction mode yesterday (-10% from its all-time bubble high in 2015)," Hedgeye CEO Keith McCullough wrote earlier this morning. It's now down -9.5% from that high today.

Phew!

"Inclusive of the Buffett-bounce in AAPL," McCullough continues, "the Nasdaq is down -4.8% in the last month alone. Lots of chart chasers are not liking their Tech charts anymore (reminder: at #TheCycle peaks of 2000 and 2008 the Nasdaq put in its YTD highs in MAR-MAY too)."

The fact that it missed expectations so badly and the stock subsequently sold off near 8% (big for TGT – only 7 times in 10 years it traded down that much, and all were in the Great Recession) does not mean that our cautious view is realized. Quite the opposite…the numbers that we saw if nothing else validate the issues that we think will plague this company for years to come.

Think of it like this…

Retailing is a full-contact sport. Sometimes the best retailers miss, and the worst retailers beat. Neither success nor failure are linear – ever. But this event is not simply an otherwise great company (which, in all fairness, TGT probably is) catching a bad break. It is the poster child for a ‘retailer behaving badly’, that we think will result in share loss in coming years. Here’s what we’re thinking…

‘Behaving Badly’. Let me define ‘behaving badly’ before I catch flack on it from the TGT bulls (which will happen anyway). I’m referring to investing in the business to gain share on a consistent basis and take financial returns meaningfully higher. I love when I hear CEOs say ‘It’s really a tough retail climate’. It’s ALWAYS a tough retail climate. That’s what retail has been in the 2+ decades I’ve covered it. That’s why our internal idea sourcing tools are overwhelmingly levered to changes in SG&A, capex and working capital. These tools and processes back-test better than anything else. Target fails on every one of them.

This Really Wasn’t A Beat. Target beat this quarter for one reason and one reason only – it had a -7.8% decline in SG&A on a +1.2% comp. Yes, much of the SG&A decline was associated with the CVS Rx deal. But even excluding that we saw 50bps of cost leverage on such a menial comp. That’s not normal.

Capex Continues to Be Light. Too light. Last year the company said it would come in between $2-$2.5bn in capex. When all is said and done in came in at $1.4bn. This quarter, we’re looking at $285mm in capex, which is down 18% from last year. Bulls might like this. We don’t. Keep reading…I’ll get to the point.

Deteriorating Working Capital. Working capital trends look worse for Target than we’ve seen since the Steinhafel years. Seriously…look at TGT’s SIGMA. It made a swift move to Quad2. That, by a country mile, is the most dangerous place to be. It’s when inventory is building relative to sales but management is complacent because margins are positive. Over 90% of the time, the move from this position in the SIGMA is bad – both financially, relative to expectations, and for the stock.

Buy The Peaks. Instead of investing in its infrastructure – both capex and SG&A – keeping in mind that about 70% of all SG&A dollars are associated with a head -- TGT bought $900mm in stock near its all-time high. Well isn’t that special. So let me get this straight, it’s investing less in the infrastructure, but buying more of the public equity?

If TGT is investing in the wrong places, everyone else must me as well, right? Nope. Ever hear of a company called Wal-Mart? Yeah…last year the company said that earnings would be largely flat over four years while it invested in e-commerce, labor costs, stores, vendors, and talent at Corporate. TGT is foolish to ignore any competitor, and by its actions...it is. But it absolutely cannot be backing off investment spending while its top competitor is going full-throttle, and AMZN is making an incremental push into consumables and pretty much everything else TGT sells.

Additional Details on the Quarter…

“Need to learn more, check back in later”. We are paraphrasing the closing comments made by CFO, Cathy Smith, in her portion of the prepared remarks as it left a bad taste in our mouth. Especially in light of the fact that management held guidance for the year – despite a sales miss in the 1st quarter, extremely bearish commentary on the promotional posture of the peer group and resulting pressure to margins, as well as flat to negative same store sales guidance for the 2nd quarter. There seems to be a whole lot of hope baked into those forecasts. Which seems to be the trend across retail in this earnings season. Of the big four mid-tier players in the general merch/dept store space who have reported to date, only Macy’s ripped the band-aid taking full year guidance down 15%, everyone else (JCP, KSS, and TGT) kept earnings guidance in check for the year.

If this is truly just a one quarter weather induced blip that drastically affected consumer spending across the entire category in the months of April and first two weeks in May, then we might be eating crow. But, we and our firm wide Macro view strongly disagree. Keep in mind that TGT called out weather as a negative in the Northeast last year in 1Q as snow blanketed much of the region, now mild weather has somehow compounded the problem.

Where’s The Investment: We haven’t seen it under Cornell’s year and a half tenure at the company. Some of the cuts he made were obvious – Canada and corporate employee overhead. Others opportune – CVS pharma deal. But, now the low hanging fruit on the tree is picked. And, its competitive set is spending up big. WMT earnings expectations for FY17 (calendar ’16) have come down by $2.07 over the past 24 months due to strategic investments in vendors, price, employees, and e-comm. Plus AMZN, who everyone and their brother has pegged as the biggest enemy to brick and mortar retail, doesn’t have much of an operating margin to protect. Over that same time period, what has TGT done? a) Underinvested by as much as $700mm on the capex line in 2015 vs. the stated plan, and b) posted negative organic SG&A growth of -3.3% and -1.6% in the past two quarters, respectively.

Keep in mind that the plan for TGT to keep EBITDA Margins steady over the long term at a Pharma adjusted rate of 10.5%, the company needs to produce 3% comps. But retail 101 says that a company cannot manufacture unprecedented comp rates (it’s been over 8yrs since TGT posted consecutive years of +3% comp rates) without a significant investment on the SG&A or CapEx lines…preferably both. So, TGT can continue to financially engineer earnings growth through share buybacks and underinvestment in SG&A at the risk of long term market share.

Driving Comp Through GM: Over the past two quarters, each of which we would characterize as low quality prints, TGT has propped up the top line with increased promotional activity. Though this quarter, the promotional activity was masked by the pharma sale, core GM was down 20bps -- a slight increase from the -50bps seen in 4Q15, but we also saw a 110bps sequential deceleration in the 2yr comp. That pressure will continue to persist for TGT, as inventory isn’t just way out of whack in the industry (as management noted a number of times on the call), but is on the balance sheet for TGT. Long-term guidance calls for flat Gross Margins at a pharma adjusted rate of 30%, but this race to the bottom on price and quarterly volatility go a long way in proving that the targets Target laid out two months ago are incredibly optimistic. Not to mention the gross margin drag from e-commerce growth. That will more than offset any supply chain benefits Mulligan’s 7 minutes of real estate on the call would otherwise suggest.

Cat & Jack: To be clear, let’s call this brand what it is. A private label kids apparel line that is not entirely incremental (it will take floor space away from existing product), that has no brand recognition yet. Assuming that the brand started off out of the blocks in the 2nd half of 2Q16 at a $1bn run rate and was entirely incremental the best it could add would be 70bps of comp. We, however, know that it won’t either a) start off at a $1bn run rate, or b) be entirely incremental. To talk to the comp lift potential of a private label brand with a $1bn target for a company with a revenue base of $70bn seems entirely off topic for a management team that doesn’t have a firm grasp on the reasons for the slowdown in consumer demand in the first place.

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05/18/16 02:13 PM EDT

FLASHBACK | McGough: Target Is A ‘Killer Name On The Short Side’

Earlier today, Target management blamed an “increasingly volatile consumer environment” for its weak earnings and guidance. Its shares fell as much as 9% on the news. In this prescient HedgeyeTV video flashback from last week, our Retail analyst Brian McGough discussed why Target (TGT) was among his top short ideas ahead of today’s earnings release.

Credit Drought: A Weary Road Ahead For The Ag Sector

Editor's Note: Below is a brief excerpt and charts from an institutional research note written by Materials analysts Jay Van Sciver and Ben Ryan with critical insights for the Ag industry and specifically companies like Agrium (AGU), CF Industries (CF), Mosaic (MOS) and Potash (POT). To read our Materials team's institutional research email sales@hedgeye.com.

The big question that will be answered in the intermediate-term is the effect of credit contraction, repayment rates, and land values on farmer input consumption trends. As we’ve highlighted with our recent calls in the Ag. space, we believe a deterioration in these metrics will prove meaningful:

The Chicago Farm Loan Repayment Index contracted from 43 at the end of Q4 to 32 through Q1 (-44% Y/Y) while the Chicago Fed Farm Loan Demand Index increased to 156 from 134 through Q4 (+11% Y/Y) – The Chicago Fed Fund Loan Availability Index was flat Y/Y.

The Federal Reserve Bank of Chicago 7th District measurement of farmland values shows that farmland values are down -4% Y/Y, the largest rate of deceleration since Q3 of 2009. Cash rental rates for the 7th district are down -10% Y/Y.

Editor's Note: Below is a Hedgeye Guest Contributor research note written by our friend Doug Cliggott. Cliggott is a former U.S. equity strategist at Credit Suisse and chief investment strategist at J.P. Morgan. He is currently a lecturer in the Economics Department at UMass Amherst.

A brief note on our contributor policy. This column does not reflect the opinion of Hedgeye. In fact, in this instance we disagree with Cliggott. That's what makes a market. Cliggott has a keen eye for the markets and economy and, in the very least, is worth reading to challenge our own deeply-held views.

American consumer price inflation is running at about 1.0 percent so far in 2016. A year ago, it was zero. Six months from now, it will likely be around 3.0 percent and trending higher. Here’s why.

Inflation is now 1.0 percent because energy prices are lower than they were a year ago. Energy commodity prices – gasoline and heating oil – are down about 14 percent from where they were a year ago. Energy services prices – electricity and natural gas – are down about 3%.

But oil prices have bounced since February, and are now right where they were in November 2015. So if oil prices don’t change much, on balance, between now and November 2016 (not a bad bet I think) then energy will shift from being a lever pushing down on inflation to one that is pushing up on inflation next winter.

The longer-term, more-important story is what is going on with prices of services. Rents folks are paying for a house or an apartment are rising by a bit more than 3% now, and look to be trending higher. And prices of all types of services that we buy (except for energy) – like medical care, travel, going to restaurants or the movies, using the internet – they are rising by a collective 3 percent. Maybe price increases for services slow in the next 6-12 months, but I doubt it.

The reason is most of the services we buy involve quite a bit of labor. And the cost of labor is going up in America – not quickly, but at a slow and steady rate of ascent, kind of like the climb out of Keflavik Airport in Reykjavik Iceland. No need for a steep climb out of that place when there is nothing but water for hundreds of miles in all but one direction.

So-called “unit labor costs” moved up by 2.0 percent in 2014, by 2.1 percent in 2015, and by 2.3% in the first quarter of 2016. This soft trend higher isn’t because hourly compensation is accelerating – that has been growing at an unbelievable steady 2.8 percent per year since the end of 2013. What is happening is growth of labor productivity – the holy grail of economic activity – is grinding down towards zero.

No one really knows exactly how labor productivity works. We know you need good tools, good workers with the right training, good organization and management … but there also seems to be a really important role for something intangible like “chemistry” or “team spirit” in organizations that are experiencing strong growth in productivity.

Robert Gordon, in his excellent new book The Rise and Fall of American Growth, tells us about the amazing improvements in productivity that occurred in the Kaiser shipyards in Oregon and California in the early 1940s. When the yards began production of Liberty ships in 1942, the scheduled production time was eight months per ship. A year later, production time was down to a few weeks.

Gordon writes that the stunning productivity gains were "made possible in part by letters from more than 250 employees suggesting ways to make production more efficient". Gordon creates an image of an amazing team spirit in these shipyards, a spirit that seems to have been shared in many factories and work places in America during the war.

That was then. Things are different now.

Since the end of the 1970s, we have had a well-documented divergence between productivity and a typical American worker's pay. Seventy years removed from the second World War, we now have a generation of American workers who have seen very little relationship between their collective productivity and what they are paid. And the compensation numbers really have become extreme.

Think of corporate America as an American football team with twenty-two players. Twenty-one of these players earn between $15,000 and $125,000 each year, with half the team earning less $50,000 or less. But one player – the quarterback (or CEO) – earns $16,000,000 each year. Despite a pretty good won/loss record for many years, the only players' salaries that have gone up in a measurable fashion are those of the quarterback, and maybe one of his favorite receivers.

In this scenario, we really shouldn't be surprised that most "team members" are now simply showing up on game day and going through the motions. And so the team’s performance (measured productivity) has deteriorated in dramatic fashion. This may be an important part of the profound slowdown in productivity – there may not be a lot of "team spirit" in many American work places these days, but there is a whole lot of selfish behavior going on in the "quarterback fraternity".

We can see the unprecedented shares of cash flow being deployed to increase dividends and buy shares back, all in an effort to inflate stock prices and boost the compensation of those that are paid in stock. What we can’t see is the investments in new tools and training that are not being made, nor the dinner discussions of all those families that keep getting essentially the same pay check, no matter how profitable their company is.

But back to inflation – if I’m right and US inflation is on its way to about 3 percent in six months, and maybe higher than that in twelve months time, owning a 10-year US Treasury yielding 1.75% does not seem like a good idea. But perhaps owning some TIPs is a pretty good one.

RTA Live: May 18, 2016

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